Chapter 12

Answers – HKAS 36 Impairment of Assets

(I) Multiple Choice Questions

1. A HKAS 36 states that purchased goodwill must always be tested for impairment annually.

2. D

3. B HKAS 36 states that impairment losses should be allocated first to goodwill and then to other assets on a pro-rata basis, based on the carrying amount of each asset in the unit. This suggests an allocation of $30,000 against goodwill, $10,000 against patents and $20,000 against other assets (option C).

However, HKAS 16 also states that no asset should be reduced below its net selling price. Therefore the patent cannot be written down below $25,000 and the allocation is: goodwill $30,000; patents $5,000; other assets $25,000.

4. C The carrying value of the income generating unit in the consolidated accounts immediately before the impairment review is:

$m Unamortised goodwill [9/10 x ($110 – $100)] 9 Net identifiable assets 95 104

Therefore, the impairment loss is $8 million ($96 million – $104 million).

(II) Examination Style Questions

1. Recoverable amount is the higher of an asset’s net selling price (or net realizable value) and its value in use (or economic value).

Net selling price is based on the either the price in a binding, arm’s length sale agreement or a price in an active market. In either case any costs attribute to the disposal should be deducted.

Value in use is the discounted value of expected future cash flows arising from the continued use of the asset.

It may not always be necessary to estimate both net selling price and value in use. For example, if a business is using an asset profitably it can be presumed that the asset’s value in use is higher than its net realizable value. If a business is holding an asset for sale rather than use it can be presumed that the asset’s net realizable value is higher than its economic value.

Recoverable amount is an important concept in assessing whether or not the value of an asset has been impaired, i.e. there is evidence that the asset’s carrying amount exceeds its recoverable amount.

2. (a) A cash generating unit is defined as a group of assets that generates cash that is largely independent of the reporting entity’s other cash generating units.

A12-1 Chapter 12

To determine whether impairment of an asset has incurred, it is necessary to compare the carrying amount of the asset with its recoverable amount. The recoverable amount is the higher of net selling price and value in use. It is not always easy to estimate value in use. In particular, it is not always practicable to identify cash flows arising from an individual fixed asset. If this is the case, value in use should be calculated as the level of cash generating units.

(b)(i) The cash generating unit comprises all the sites at which the product can be made.

(b)(ii) Each restaurant is an cash generating unit by itself. However, any impairment of individual restaurants is unlikely to be material. A material impairment is likely to occur only when a number of restaurants are affected together by the same economic factors. It may therefore be acceptable to consider groupings of restaurants affected by the same economic factors rather than each individual restaurant.

3. HKAS 36 ‘Impairment of Assets’ says that an impairment loss for a cash-generating unit should be recognised if its recoverable amount is less than its carrying amount. An impairment loss for a cash- generating unit should be allocated in the following order:

(i) to the goodwill of the unit; then (ii) to other asset on a pro rata basis, based on their carrying amounts.

In allocating an impairment loss as above, the carrying amount of an individual asset should not be reduced to less than the highest of:

(i) its net selling price; (ii) its value in use (if separately determinable); and (iii) zero

It has been concluded that there is no practical way to estimate the recoverable amount of each individual asset (other than goodwill) as they all work together as a single unit. Nor do they believe that the value of an intangible asset is necessarily more subjective than a tangible asset.

Assets: First provision Revised assets: Second Revised assets: provision 1 July 1999 1 August 1999 30 Sept. 1999 $000 $000 $000 $000 $000 Goodwill 200 (200) nil nil Operating licence 1,200 (200) 1,000 (100) 900 Property – train stations and land 300 (50) 250 (50) 200 Rail track and coaches 300 (50) 250 (50) 200 Stream engines 1,000 (500) 500 500 3,000 (1,000) 2,000 (200) 1,800

Notes: The first impairment loss of $1 million: (i) $500,000 must be written off the engines as one of them no longer exists and is no longer part of the cash-generating unit (ii) the goodwill of $200,000 must be eliminated; and (iii) the balance of $300,000 is allocated pro rata to the remaining net assets other than the engine which must not be reduced to less than its net selling price of $500,000.

A12-2 Chapter 12

The second impairment loss of $200,000: (i)t he first $100,000 is applied to the licence to write it down to its net selling price (ii) the balance is applied pro rata to assets carried at other than their net selling prices i.e. $50,000 to both the property and the rail track and coaches.

4. (a) There normally needs to be some indication that a non-current asset has suffered impairment before carrying out a formal review. However, HKAS 36 provides for an exception to this general rule in the case of goodwill that is being amortised over a useful economic life of more than 20 years. In such circumstances, the Standard requires that impairment reviews be carried out on an annual basis. Acquirer has selected a useful economic life of 40 years for the goodwill relating to Prospects, so clearly the goodwill needs to be reviewed for impairment on an annual basis.

(b) An impairment review involves comparing the carrying value of a non-current asset with its recoverable amount. The recoverable amount is the higher of value in use and net realizable value. Many non-current assets either do not have an identifiable net realizable value or, if they do, the net realizable value is very low because the asset is held for use in the business rather than for sale. Therefore, an impairment review often involves computing value in use and this is certainly required when reviewing goodwill for impairment.

In practice, very few assets can be said to generate cash flows in isolation. What normally happens is that the cash flows are generated by a grouping of assets. A cash-generating unit is the smallest grouping of assets that can be said to generate cash flows that are independent of those generated by other units. A meaningful calculation of value in use usually involves identifying cash-generating units and the attributable cash flows. It is inevitable that goodwill is treated in this way since it clearly cannot generate cash flows in isolation.

(c) The total impairment loss in unit A is $13 million ($85 million – $72 million). This is allocated in the following order:

(i) To any assets that have suffered obvious impairment – none indicated here. (ii) To any goodwill in the unit – none specifically allocated here. (iii) To other assets in the unit, on a pro-rata basis. In this case the “other assets” are patents (carrying value $5 million) and property, plant and equipment (carrying value $60 million) and net current assets (carrying value $20 million). The net current assets cannot be written down because no current assets have a realizable value that is below carrying value.

This means that the impairment loss of $13 million is allocated:

(i) 5/65 x $13 million = $1 million to the patents. (ii) 60/65 x $13 million = $12 million to the property, plant and equipment.

(d) Because the goodwill on consolidation cannot be allocated to individual units, the impairment review needs to be performed in two parts. The first stage is to review the individual units for impairment. In this case, we see that the assets in unit A have suffered impairment.

A12-3 Chapter 12

After providing for this loss, the intermediate carrying value of the net assets of Prospects, including goodwill, is as follows:

$ million Goodwill (38.5/40 x $80 million) 77 Unit A 72 Unit B 55 Unit C 60 Total 264

Since the value in use of the whole business is $205 million, there is an additional impairment loss of $59 million that needs to be provided for. This is first allocated to goodwill and so the carrying value of the goodwill is reduced to $ 18 million.

5. (a) A review of impairment of an asset should be carried out if events or changes in circumstances indicate that carrying amount of the asset may not be recoverable. HKAS 36 has prescribed some indication of potential impairment loss, if there is some indication, the company should carry out the impairment test, if not, HKAS 36 does not require the enterprise to make a formal estimate of recoverable amount.

Indications of possible impairment to be considered on annual basis include:

External sources of information:

(i) Significant decline in the asset’s market value more than would be expected as a result of the passage of time or normal use; (ii) Significant changes in the technological, market, economic or legal environment; (iii) Increases in the market interest rate or other market rate of return on investments, and those increases are likely to affect the discount rate used in calculating the asset’s value; (iv) Declines in the enterprise’s market capitalization.

Internal sources of information:

(i) Specific evidence of obsolescence or of physical damage to an asset; (ii) Significant internal changes to the organization or its operations so that the expected useful life or utility of the asset has seemingly been reduced; (iii) Evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected.

Where any of the above situations occur, an impairment review should be carried out. In case of tangible assets, if there is no cause for impairment, then no impairment review is necessary. However, intangible assets or goodwill still require review.

(b) Original cost $1,300,000 Accumulated depreciation ($1,300,000 – 130,000)/30 for 10 years $390,000 Carrying value $910,000

Recoverable amount: Higher of value in use / NRV $750,000

A12-4 Chapter 12

Value to business: Lower of carrying value / recoverable value $750,000

Impairment loss ($910,000 – $750,000) $160,000

6. (a)(i) An impairment loss arises where the carrying value of an asset, or group of assets, is higher than their recoverable amounts. In effect the Standard requires that assets should not appear on a balance sheet at a value which is higher than they are ‘worth’. The recoverable amount of an asset is defined as the higher of its net realisable value (i.e. the amount at which it can be sold for net of direct selling expenses) or its value in use (i.e. its estimated future net cash flows discounted to a present value). HKAS 36 ‘Impairment of Assets’ recognises that many assets do not produce independent cash flows and therefore the value in use may have to be calculated for a group of assets – a cash- generating unit.

The Standard recognises that it would be too onerous for companies to have to test for impaired assets every year and therefore only requires impairment reviews when there is some indication that an impairment has occurred. The exception to this general principle is where goodwill or other intangible assets are being depreciated over a period of more than 20 years, in which case an impairment review is required at least annually. This also applies where any tangible non-current asset, other than land, has a remaining life of more than 50 years.

(a)(ii) Impairments generally arise where there has been an event or change in circumstances. It may be that something has happened to the assets themselves (e.g. physical damage) or there has been a change in the economic environment relating to the assets (e.g. new regulations may have come into force).

The Standard gives several examples of indicators of impairment, which may be available from internal or external sources:

(i) poor operating results. This could be a current operating loss or a low profit. One year’s losses in itself does not necessarily mean there has been an impairment, but if this is coupled with previous losses or expected future losses then this is an indication of impairment; (ii) a significant decline in an asset’s market value (in excess of normal depreciation though use or the passage of time) or evidence of obsolescence (through market changes or technology) or physical damage; (iii) evidence of a reduction in the useful economic life or estimated residual value of assets; (iv) adverse changes in the market or economy such as the entrance of a major competitor, new statutory or regulatory rules or any indicator of value that has been used to value an asset (e.g. on acquisition a brand may have been valued on a ‘multiple of sale revenues’. If subsequent sales were below expectations this may indicate an impairment.); (v) a commitment to a significant reorganisation or restructuring of the business; (vi) loss of key employees or major customers; (vii) increases in long-term interest rates (this could materially impact on value in use calculations thus affecting the recoverable amounts of assets); (viii) where the carrying amount of an enterprise’s net assets is more than its market capitalisation.

(b)(i) On the acquisition of a subsidiary, the purchase consideration must be allocated to the fair value of its net assets with the residue being classed as goodwill (or negative goodwill if the assets have a greater fair value than the purchase consideration). HKFRS 3 ‘Business Combinations’ recognises

A12-5 Chapter 12

that it is not always possible to accurately determine the value of some assets at the date of acquisition and therefore allows an ‘investigation period’ up to the end of the first full reporting period following the period of acquisition. As the revision to the value of Halyard’s assets was due to more detailed information becoming available, the fall in its asset values should be treated as an adjustment to provisional valuations made at the time of acquisition. In effect the net assets and goodwill should be restated to $7 million and $5 million respectively; the fall of $1 million is not an impairment loss and should not be charged to the income statement. This revision will have the effect of increasing the amortisation of goodwill from $800,000 to $1 million per annum (based on a five-year life). The above assumes that the recoverable value of the company as a whole is greater than $12 million.

The fall in value of Mainstay’s assets is the result of events that occurred after the acquisition (i.e. physical damage to the plant) and this does constitute an impairment loss. The plant and machinery should be written down to its recoverable amount and the loss charged to the income statement. On the assumption that the recoverable value of the company as a whole has not fallen, goodwill will not be affected.

(b)(ii) On the basis of the original estimates, Shiplake’s earth-moving plant was not impaired, the value in use of $500,000 being greater than its carrying value. However due to the ‘dramatic’ increase in interest rates causing Shiplake’s cost of capital to increase, the value in use of the plant will have to be recalculated. As the discount rate has risen this will cause the value in use to fall. There is insufficient information to be able to quantify this fall. If the new discounted value is above the carrying value $400,000 there is still no impairment. If it is between $245,000 and $400,000, this will be the recoverable amount of the plant and it should be written down to this value. As the plant can be sold for $250,000 less selling costs of $5,000, $245,000 is the least amount that the plant should be written down to even if its revised value in use is below this figure.

(b)(iii) The treatment of the research and development costs in the year to 31 March 2001 was correct due to the element of uncertainty at the date. The development costs of $75,000 written off in that period should not be capitalised at a later date even if the uncertainties leading to its original write off are favourably resolved. The treatment of the development costs in the year to 31 March 2002 is incorrect. The directors’ decision to continue the development is logical as (at the time of the decision) the future costs are estimated at only $10,000 and the future revenues are expected to be $150,000. It is also true that the project is now expected to lead to an overall deficit of $135,000 (120 + 75 + 80 + 10 – 150 (in $000)). However, at 31 March 2002 the unexpensed development costs of $80,000 are expected to be recovered. Provided the criteria in HKAS 38 ‘Intangible Assets’ are met these costs of $80,000 should be recognised as an asset in the balance sheet and ‘matched’ to the future earnings of the new product. Thus the directors’ logic of writing off the $80,000 development cost at 31 March 2002 because of an expected overall loss is flawed. The directors do not have the choice to write off the development expenditure.

(b)(iv) An impairment loss relating to an income generating unit should be allocated on the following basis: first to any obviously impaired assets (none in this example); then to goodwill; then to the remaining asset on a pro-rata basis; but no asset should be written down to less than its net realisable value. Applying this to the impairment loss of $130 million ($370m – $240m):

A12-6 Chapter 12

Cost Impairment Restated value $000 $000 $000 Goodwill 80,000 (80,000) Nil Franchise cost 50,000 (20,000) 30,000 Restored vehicles 90,000 Nil 90,000 Plant 100,000 (20,000) 80,000 Other net assets 50,000 (10,000) 40,000 370,000 (130,000) 240,000

Note: the franchise cost cannot be written down to less than its realisable value, the restored vehicles have a realisable value higher than their cost and should not be written down at all, the remaining impairment loss (after the goodwill and franchise write downs) of $30 million is apportioned pro-rata to the plant and the other net assets.

A12-7